40123Th - Milken Institute · 2014. 4. 1. · 44 The Milken Institute Review Iceland’s three main...

40 The Milken Institute Review

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iceland

WWhat comes to mind when you think about Iceland? Until recently, chances are it con-

jured up images of puffins or geysers or maybe Björk – or, if you’re a history buff, Ron-

ald Reagan plotting a nuclear-free world with Mikhail Gorbachev.

41First Quarter 2010

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after the fallb y t h o r v a l d u r g y l f a s o n

p h o t o g r a p h s b y r a g n a r a x e l s s o n


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Today, alas, nostalgic thoughts have been crowded out by

the grim reality of the financial meltdown: no economy

on earth suffered comparably severe damage.T


Iceland’s three main financial institutions, which accounted for 85 percent of its banking system, crashed within a single week in Octo-ber 2008. All three (along with the govern-ment that had encouraged their forays into the Himalayas of global finance) claimed that they were merely pawns caught in Wall Street’s nefarious games. But the truth is more sobering. For this crisis has exposed the fundamental weakness of Iceland’s economic and political cultures, which are hobbled by institutions more akin to those of the Third World than the First.

how iceland caught upTo understand Iceland’s fall from grace, one must understand how it managed to do so well for so long. When Iceland was granted home rule from Denmark in 1904, income per capita was about half that of its colonial parent – a miserable $1,500 in today’s pur-chasing power. But the island’s people were better prepared for modernity that one might infer from that figure. Going back as far as 1800, most Icelanders were literate. Thus, it should not be entirely surprising that Iceland managed to average about a half a percentage point faster growth than Denmark over the course of the 20th century, or that this mod-est advantage enabled Iceland to catch up.

What’s more, it used the income well, transforming an island in the middle of the North Atlantic into a prosperous state with little or no poverty. In 2006, the United Na-tions Human Development Index ranked Ice-land first in the world, tied with egalitarian, oil-glutted Norway.

Over the years, Iceland accumulated vari-ous sorts of capital at a rapid pace: physical

capital through investment; human capital through education; foreign capital through trade; and social capital through democracy, institution-building and a dedication to equal-ity. Natural capital also played a role – first, in the form of rich fishing grounds (thanks to the Gulf Stream), and later in hydropower and geothermal energy. Even the preference for small families (and the lack of hospitality to immigrants), which kept Iceland’s total popu-lation of 320,000 below that of Bakersfield, Calif., proved no economic handicap. To the contrary: the inefficiencies associated with lack of scale were probably more than offset by the gains linked to social cohesion.

In foreign relations, Iceland deferred to its Nordic neighbors. It entered the European Economic Area along with Finland, Norway and Sweden in 1994, which gave it easy access to European markets. But Iceland chose to re-main apart from the European Union – a choice that reflected some Icelanders’ prefer-ence to chart an independent economic course.

In domestic affairs, Iceland departed in some ways from the Nordic norm. While two-thirds of Icelanders live in greater Reyk-javik, rural areas are vastly over-represented in the Icelandic parliament – and institutions were accordingly skewed in favor of farmers, fishing boat owners and local businesses. Free markets were viewed with skepticism, if not outright hostility. The state owned the large commercial banks and used them to allocate subsidized loans and to ration access to for-eign currency. There was no way to borrow to build a fence, buy a car or obtain dollars to go abroad without kissing the rings of political functionaries.

This was, it should be added, capital ra-tioning with a human face. Even so, the all-encompassing role of the political class in the economy inevitably led to the soft corruption of patronage and to influence-peddling.

Thor Gylfason is professor of economics at the University of Iceland.

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The stories are legend. Party cronies usurped representation of major firms like Coca-Cola and General Motors by convinc-ing their foreigner partners that only they would be able to procure the permits needed to import foreign exchange. Political leaders sat on the boards of the banks, looking after supporters in the business community who could not manage without preferred access to capital.

Bank profits were in effect channeled to fa-vored clients through low-interest loans, while losses were passed on to the public in the form of high fees and state backing of bank liabilities. This convenient bargain –

privatizing the gains and nationalizing the losses – was rarely challenged. The political opposition, after all, had representatives on the bank boards, too. The newspapers, mostly organs of the political parties, stayed in line, as did prosecutors and the courts.

lopsided liberalizationTwo waves of liberalization of the policy re-gime did relieve some of the economic drag associated with Iceland’s brand of crony capi-talism. The first, in the early 1960s, drastically reduced subsidies to the fishing industry – subsidies that had absorbed an astounding 40 percent of the government’s budget. The

While two-thirds of Icelanders live in greater Reykjavik,

rural areas are vastly over-represented in the Icelandic

parliament — and institutions were accordingly skewed in

favor of farmers, fishing boat owners and local businesses.


króna was also devalued, making Icelandic enterprises more competitive in export mar-kets. But as economic reforms go, this one fell short. For one thing, it left the banks – and thus the allocation of capital – in the hands of politicians. More generally, it did not loosen the suffocating embrace between producers and their patrons in government.

A second wave of liberalization in the 1980s deregulated interest rates. This made it possi-ble for those rates to rise above the (chroni-cally high) rate of inflation, reducing the im-plicit subsidies funneled through the banks. Selective forgiveness of non-performing loans effectively took the place of credit rationing.

Once Iceland joined the European Eco-nomic Area in 1994, the government effec-tively abandoned controls over trade and cap-ital flows. The privatization of commercial banks and investment funds followed from 1998 to 2003. But before analyzing the impact of the deregulation and privatization of fi-nancial markets, it makes sense to look more closely at the broader real economy.

Iceland may have come out on top of the UN’s Human Development Index in 2006 (and a more-than-respectable third in 2009), but it lagged by narrower measures of eco-nomic development. In 2008, the purchasing power generated per hour worked in Iceland averaged $40 – far below Norway ($69), the United States ($55) and Germany ($50), and even a bit below Italy and Spain. Icelanders certainly live well, but only by working longer hours than other Europeans. The best expla-nation: protection of agriculture and a lack of competition in key sectors (notably banking) raise the cost of living and weigh heavily on productivity.

Other factors are at play here, too. Iceland lags in investment in machinery and equip-ment, most likely because the financial sector

favored less-productive investment in real es-tate. And despite great strides on the educa-tion front in recent years, the share of the Ice-landic labor force (25- to 64-year-olds) with no more than a high school education is still twice that of the Scandinavian countries.

It’s also worth noting that the central bank, so long compromised by the less-than-arm’s-length relationship between policymakers and the private sector, has never managed to make price- and exchange-rate-stability a pri-ority. One number says it all: Since 1939, when the two traded at par, the Icelandic króna has lost 99.95 percent of its value relative to its mother currency, the Danish krone.

privatization among friendsReturn now to the privatization of Iceland’s big banks – in particular, Landsbanki Íslands and Búnadarbanki Íslands, two of the largest. (The latter was subsequently merged into the Kaupthing Bank in 2003). The recent experi-ence of the Baltic countries in the transition from Soviet-style planning offered plenty of precedent in how to manage such privatiza-tions. The idea was to maximize the return to the state by casting the net widely for bidders and by seeking buyers that could manage in-ternational banking in a small country de-pendent on trade and foreign investment.

But in Iceland, the two banks were sold at prices deemed suspiciously low by the Na-tional Audit Office. What’s more, they were sold to Icelanders lacking experience in the business.

Why? Because it suited the ruling Indepen-dence and Progressive parties – or, more pre-cisely – some leading politicians who saw privatization as a chance for their cronies to become richer. One major investor was a pol-itician whose private-sector experience con-sisted of running two small knitwear factories in the provinces in the 1970s for a few months;

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he became an instant billionaire. Another needed special legislative treatment to qualify because he had been in deep legal trouble in Russia. Previously, he had been awarded a conditional prison sentence in Iceland for fraud. To make matters worse, his son and co-investor was a wheeler-dealer who had made his mark on the world stage through shady privatization deals in the telecommunications business in Bulgaria and the Czech Republic.

Crony capitalism was so much a part of daily life in Iceland that this back-scratching was openly discussed. Consider an essay cele-brating the prime minister – one presumably published with the subject’s approval – in the newspaper Morgunbladid in 2004. The essayist wrote that, since the Progressive Party (then the second-largest party) had secured its claim to the Búnadarbanki, the prime minister “con-sidered it necessary that Landsbanki would land in the hands of persons within at least calling distance of the Independence Party.”

And how, you might wonder, did the ousted central bank governor under whose steward-ship as prime-minister-turned-banker all this transpired, fare after the system collapsed? He became editor of Morgunbladid – roughly the equivalent of making Richard Nixon the edi-tor of the Washington Post to ensure fair and balanced coverage of Watergate.

The point of bank privatization ought to have been the creation of independent institu-tions with incentives to allocate capital to its most productive and profitable use. But the political culture of Iceland saw it quite differ-ently: this was a grand opportunity to reward friends and family. And in this sense, Iceland, which is typically cast as an extension of Scan-dinavia in the middle of the Atlantic, was (and is) very different than its Nordic cousins.

Privatization thus generated the worst of all possible worlds, reducing the stability of Iceland’s financial system without increasing

its efficiency. The government could have changed the banks’ incentives to take enor-mous risks in search of profit through changes in taxes. But it did not – you do not tax your friends. The central bank could have con-tained the explosion of liquidity that followed privatization through higher reserve require-ments. But it did not: on the contrary, it low-ered reserve requirements in 2002 at the banks’ behest. And – this proved a particu-larly expensive error – it abolished all reserve requirements on the banks’ deposits at branches in other countries.

Iceland’s Financial Supervision Authority had the discretion to apply stress tests, tai-lored to the quality and volatility of the banks’ assets. But it was hopelessly compromised. The banks routinely hired away personnel from the authority at fat salaries, thereby de-priving it of experienced staff and conveying a clear message to those who remained behind.

Free to do what they pleased, the banks went on an unprecedented borrowing and lending spree that increased the assets of the banking system from about 100 percent of national income in 2000 to an astonishing 900 percent in mid-2008. The banks’ business model was, in essence, imported from abroad. Loan officers were rewarded according to the volume of loans they made, regardless of

One major bank investor was a

politician whose private-

sector experience consisted

of running two small knitwear

factories in the provinces in

the 1970s for a few months; he

became an instant billionaire.


quality. The banks even managed to convince large numbers of customers to borrow in for-eign currencies, even though the customers’ earnings were solely in Icelandic currency.

That practice may or may not have been legal. But it was certainly imprudent: Com-paring the market exchange rate of the króna with its relative purchasing power suggests that Icelandic currency was at least 50 percent overvalued in 2008. And while it’s true that ex-change rates often wander far from purchas-ing-power parity, the idea that most Icelandic businesses would bet their futures on the con-tinuing misalignment of currencies is bizarre.

Lack of due diligence seemed the order of the day. The banks claimed to believe – as did at least one international rating agency – that the government continued to guarantee all the banks’ liabilities after they were privatized. Moreover, the government did little to coun-ter that impression. The Financial Supervision Authority was featured prominently in bro-chures from Landsbanki offering high interest rates on British pound sterling “Icesave” ac-counts that foreigners opened and main-tained over the Internet.

These high-interest-rate accounts were first offered to British depositors in 2006, and morphed into a primary source of capital for Landsbanki as it became increasingly difficult for the bank to borrow abroad through con-ventional channels. Similar accounts were of-fered to Dutch depositors in 2008, even after the Central Bank of Iceland, the Financial Su-pervision Authority and the government had been sternly warned by foreign central banks that Iceland’s banks were headed for collapse.

During their brief existence, Icesave at-tracted 300,000 depositors in Britain and 100,000 in the Netherlands. Landsbanki ran its offices in those countries as branches rather than as subsidiaries, for a very good

reason: as accounts in foreign subsidiaries, Ic-esave accounts would have been subject to fi-nancial supervision by foreign regulators.

When Landsbanki became terminally illiq-uid (and surely insolvent) in October 2008, the foreign depositors were compensated in full by their governments – which, in turn, demanded that Iceland pay them back. In ef-fect, then, Landsbanki managed to make Ice-land’s population of 320,000 liable for the losses of 400,000 foreign depositors.

Actually, the story gets worse. The banks peddled loans as well as complicated financial instruments to the holders of fishing quotas and farm-production quotas, using the quo-tas as collateral. They actively encouraged de-positors to transfer their savings from ordi-nary accounts covered by government deposit insurance to money-market accounts paying higher interest, implying that the money-market accounts were also government- guaranteed. The banks also provided large loans without collateral to customers who wanted to speculate on the foreign-exchange market. And they lent members of their own senior staffs huge sums to buy shares in the banks, using only the shares as collateral.

folly proves infectiousIceland’s financial mania extended well be-yond the banking system. Between 2001 and 2007, stock market shares rose an average of 44 percent annually – a world record. Mean-while, house prices rose two-and-a-half-fold. When Robert Aliber, an economist from the University of Chicago, visited Iceland in 2007, he predicted a bust within a year. “You only need to count the cranes,” quipped the pro-fessor, an expert on asset bubbles.

And, of course, Aliber was right. Iceland became the first wealthy country to seek help from the IMF since Britain extended a palm in 1976. The massive rescue package also

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drew on money from the Nordic countries, Poland and the European Union.

As part of its recovery plan, the govern-ment split the three failed banks into “new” banks and “old” ones. The new banks took over domestic deposits and provided uninter-rupted banking services at home – no small feat under the circumstances – and received fresh injections of capital from taxpayers. The old banks were left with the dodgy assets and foreign debts that will largely have to be writ-ten off in the ensuing liquidations, no doubt triggering litigation from disappointed over-seas creditors. In effect, the banks were rena-tionalized on the model used by Nordic gov-ernments to handle their own banking crises

of 1988 to 1993. Iceland ultimately plans to re-privatize the new banks by exchanging their debts for equity – inviting, at long last, foreign ownership.

Some other businesses, by the way, suf-fered the same fate in the crisis as the banks. One of the largest insurance companies, as well as the iconic national airline – the airline that millions of Europeans and Americans have used over the decades to cross the Atlan-tic – had to be nationalized. No doubt other businesses will follow.

Iceland’s economic crisis has destroyed wealth that was equivalent to approximately seven times the country’s annual income – that’s right, seven times GDP. The damage

When Robert Aliber, an economist from the University

of Chicago, visited Iceland in 2007, he predicted a

bust within a year. “You only need to count the cranes,”

quipped the professor, an expert on asset bubbles.


that was inflicted on foreign creditors and de-positors amounts to about five times Ice-land’s national income, while the losses thrust upon Icelandic residents amount to about twice income.

With the benefit of hindsight, it’s clear how all this happened. The absence of checks and balances gradually eroded the inhibitions of unprincipled politicians and their greedy counterparts in the private sector. When, for example, the National Economic Institute, a decades-old institution set up to offer impar-tial economic counsel to the government, was no longer found to be obliging enough, it was disbanded – on the grounds, among others, that the recently privatized banks’ economic-

research departments could fill the gap. And when the Competition Authority raided the offices of oil companies in search of evidence of price collusion, it was summarily abolished and then reincarnated under new, more com-pliant management. Iceland, you see, is not so much a scaled-down version of Scandinavia as it is an amalgam of Italy, Japan and Russia, with a dash of Denmark for show.

The people of Iceland have expressed their anger at the political establishment, sweeping both the Independence Party and the Pro-gressive Party into opposition at once for the first time in history. Even before the crash, opinion polls showed that only 30 percent of Icelanders had confidence in the parliament

The people of Iceland have expressed their anger at the political establishment, sweeping both the

Independence Party and the Progressive Party into

opposition at once for the first time in history.


or the judicial system. The public’s percep-tion of those who brought down the econ-omy was neatly captured by the writer Einar Már Gudmundsson in a story about a canni-bal flying first class. When a flight attendant hands him the menu, he looks at it and says:

“Nothing on the menu strikes my fancy. Could you please show me the passenger list?”

reading the tea leavesIceland now faces gross public and private foreign debt equivalent to about 300 percent of national income, even after writing off pri-vate debts equivalent to another 500 percent. The government was thus forced to spend al-most as much on interest payments in 2009 as on health care and social insurance.

There is bound to be friction over how this interest burden is apportioned in coming years. A decade ago, Iceland could boast of an income distribution similar to that of egali-tarian Scandinavia. But, due in large part to a reduction in tax rates on high earners, the distribution is now closer to that of the United States. And in the lean years ahead, there will be pressure to pare government in-come transfers. That spells trouble for a gov-ernment asking for the major sacrifice in liv-ing standards needed to repay Iceland’s external debts.

It’s not surprising, then, that the burden has been likened to the reparations imposed on Germany at Versailles, and some observers predict equivalent consequences – though ob-viously ones that will concern the world less.

There are still some optimists out there, however. Those who focus on Iceland’s strong fundamentals remain hopeful that the coun-try can get back on its feet within a few (albeit difficult) years. For while the economy re-mains dependent on a mature fishing indus-try for two-fifths of its export earnings, it still has great potential to grow in other sectors.

Abundant hydropower and virtually unlim-ited geothermal resources make it an ideal lo-cation for producers of energy-intensive ma-terials like aluminum and ferrosilicon. And, thanks to its highly educated technocratic elite, Iceland has had some striking successes in developing information technology.

Recovery must rest on two pillars. First, the government will have to implement the IMF’s reconstruction program. Iceland’s be-lated application for EU membership (and the implied willingness to follow EU rules on governance) is evidence that the government really does intend to clean up its act.

Second, Iceland’s political establishment must face up to the causes of the collapse, in-cluding the massive failure of policy and in-stitutions in the absence of checks and bal-ances. For this to be done properly, the country will need objective analysis from out-siders. The government, however, remains unwilling to appoint an international com-mission, and that risks a deepening crisis of confidence if a home-grown review doesn’t convince the public that the skeletons aren’t being buried.

Happily, the government has accepted an offer of help from Eva Joly, a renowned French-Norwegian investigative magistrate who led an investigation of the oil giant Elf Aquitaine, arguably the biggest fraud inquiry in Europe of the postwar era.

For those who take the long view, Iceland’s fall from grace should not be all that surpris-ing. In the 19th century, the tail end of the Little Ice Age, the worsening climate effec-tively destroyed Iceland’s agricultural econ-omy and forced a good portion of the popu-lation to emigrate. But Iceland is also a country that has made the most of relatively little through hard work and a knack for adapting to change. Don’t count it out just yet. m

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